The price of getting back to work

Inflation may help determine how fast labour markets recover from recession

IT IS something of a mystery, and not as happy a one as it sounds. In both America and Britain, the unemployment rate has fallen far faster over the past year than the tepid recoveries in both countries seem to justify. The pace of the decline has already caused difficulties for Mark Carney, the newish governor of the Bank of England, and will soon do so for Janet Yellen, who on February 1st takes over as head of America’s Federal Reserve. Both central banks gave “forward guidance” about when they might consider raising interest rates tied to levels of unemployment that will now be reached much sooner than either expected. Understanding the surprisingly quick fall and responding to it appropriately may be the pivotal task of the two central bankers’ tenure.

On the face of things, Britain’s drop looks the more meaningful: it is down to rapid employment growth, whereas America’s owes a great deal to frustrated workers leaving the labour force. The British and American economies have diverged markedly in recent years. Output in both economies tumbled sharply in 2008-09. Yet America’s GDP bounced back relatively quickly, reaching a new high by early 2011. Employment in America, by contrast, suffered a more dramatic decline and a weaker recovery. In Britain the trends were reversed. Output suffered a brutal decline and a feeble rebound, prompting fear of a looming employment disaster. Yet the downturn in employment was unexpectedly mild (see chart 1).

This divergence is commonly explained with nods to Britain’s “productivity puzzle”. America, the thinking goes, suffered a “normal” recession. Its low rate of inflation is symptomatic of weak demand, which can account for its output loss and much of the shortfall in jobs. In Britain, in contrast, tumbling demand has been matched by a strange decline in workers’ productivity. Falling productivity cushioned the economy against large job losses, since more workers were needed to do the same amount of work. But it also reflected a loss of productive capacity, the evidence for which was stubbornly high inflation. Since late 2007 annual inflation in Britain has been almost twice as high as in America, at 3.1% to 1.8%.

This explanation just deepens the mystery, however, for why should a nation of workers suddenly become worse at producing things? Bill Martin and Robert Rowthorn, of the University of Cambridge, argue that those puzzling over Britain’s productivity may have causation the wrong way round: wages did not fall in response to declining productivity; declining productivity was instead a consequence of falling real wages.

The change in the real wage is simply the change in the nominal wage—the one listed in the contract or on the payslip—adjusted for inflation. Since the end of 2007, nominal wages in Britain have risen by about 1.6% a year on average. But annual inflation of more than 3% over that period generated a cumulative decline in real wages of 7.8%. British workers became cheaper relative to the prices of goods and services (see chart 2).

Moderately high British inflation may therefore have been the difference between a jobless recovery and a job-filled one. Studies suggest that nominal wages are generally “sticky”: it is hard to make existing workers take a pay cut in hard times, due to contract requirements, issues of worker morale, and other complications. Moderate inflation rates can restore wage flexibility by eroding the real purchasing power of a given wage rate. Messrs Martin and Rowthorn reckon that lower real wages encouraged firms to use more labour and less capital in production. That caused productivity to fall but propped up employment.

America’s nominal wage growth has been similar to Britain’s, but inflation has been far milder. As a result, America’s real wages have actually gone up since late 2007, by about 2%. That, in turn, may have discouraged hiring and encouraged firms to squeeze higher levels of productivity from existing workers.

Wages v jobs

A new working paper from the National Bureau of Economic Research by Mark Bils and Yongsung Chang of the University of Rochester and Sun-Bin Kim of Yonsei University in South Korea supports that view. The authors find evidence that in industries with inflexible wages firms respond to weak demand by pushing workers to produce more. Productivity in such industries rises in recessions, reducing the real cost of employing a given worker. But because firms can then use fewer employees to meet reduced demand, they have little incentive to hire.

The authors suggest that when sticky wages are a constraint, a given shock to demand should produce a large drop in employment. In America low inflation impeded wage adjustment, leading to rising productivity and weak employment growth. In Britain higher inflation kept wages in check, encouraging firms to hire despite weak demand.

Uncovering why reduced wages should be necessary to put people to work is a trickier matter. In a 2012 paper Guillermo Calvo and Pablo Ottonello, of Columbia University, and Fabrizio Coricelli, of the Paris School of Economics, blame financial havoc. After crises chastened banks are willing to lend only to firms with tangible capital—like buildings and equipment—that can be seized after a default. Firms that rely more on machines than labour therefore perform better in the recovery, pushing down demand for workers. Without a big drop in wages, weak demand for labour yields a jobless recovery. The economists examine data on financial crises since the second world war and find that post-crisis recoveries are jobless when inflation is low, but merely “wageless” when inflation is relatively high. Low inflation may help consumers in good times, but higher inflation is a useful shock absorber when recession strikes.